Agency Costs and Foreign Institutional Investors in India

Transcription

1 SAI Agency Costs and Foreign Institutional Investors in India Abstract Asish K Bhattacharyya 1 * and Sadhalaxmi Vivek Rao 2 Center for Corporate Governance, Indian Institute of Management Calcutta, West Bengal, India Financial markets are the catalysts and engines of growth of any nation. Since its liberalization in 1991, India has initiated several steps to strengthen its financial system. The financial sector reforms undertaken by the Government of India and the Securities and Exchange Board of India (SEBI) 3, over the last few years have augmented the magnitude of FDI and FII inflows. The FDI inflow for the FY ended 1991 is US$ 97 million and the corresponding figure for the FY 2004 (P) 4 is US$ 4,675 million. The corresponding figures for FII inflows are US$ 6 million and US$ billion, respectively. The remarkable increase in the FDI s and FII s is due to the friendly enabling environment, significant improvement in terms of the efficiency of the capital markets and the protection of the investors. India, one of the biggest emerging markets, is currently an important destination for FDI and FII inflows. SEBI has undertaken important policy reforms to attract new investments into the country. This empirical study endeavors to find the effect of the contemporary changes in the corporate governance structures on the agency costs of the publicly traded companies; primarily to study the effect of FII shareholding on the agency costs of publicly traded companies. The results show that FII s are effective monitors in reducing the agency costs. JEL Classification: G18, G34, M41, N25 Keywords: Corporate Governance, Foreign Institutional Investment, Agency Costs, Promoter ownership, Asset Turnover Ratio, SEBI The authors acknowledge the suggestions and comments given by Prof. V. N. Reddy, Indian Institute of Management Calcutta, India and Prof. Ajitava RayChauduri, Jadhavpur University, Kolkata. 1 Professor of Finance and Control, and Coordinator of Centre for Corporate Governance, Indian Institute of Management Calcutta, India * Corresponding author. Tel.: ; Fax: address: akb@iimcal.ac.in, akbhattarcharyya@yahoo.com 2 Doctoral Student in the Finance and Control Group of the Indian Institute of Management Calcutta, India address: sadha@iimcal.ac.in, sadhalaxmi@yahoo.com 3 The apex body for regulating the listed companies and stock exchanges in India 4 Projected by the Reserve Bank of India. 1

2 1 Introduction The integration of the economies throughout the world has accelerated during the second half of the last decade. Globalization has made economies dependent on each other for trade, manufacturing and capital, and hence more vulnerable to adverse changes in the international environment. The crisis in the East-Asian region can be partially attributed to the inaction by the concerned policy makers on the corporate governance and the disclosure by firms. The repercussions of this crisis has affected the entire region and lasted much longer than expected. Given this, a sound financial system in an economy is indispensable to protect itself from any financial crisis and for attracting long-term funds. Good investor protection leads to higher economic growth through savings, capital accumulation and efficient resource allocation (La Porta et al (1999)). The ongoing integration of the world economies and the limited disclosures by the Indian companies, have compelled the Indian capital markets regulator, SEBI, to formulate regulations on the issues of corporate governance and the financial disclosures. Upon the recommendations of the Kumaramangalam Birla Committee, it has enforced a regulation requiring a change in the corporate governance mechanisms and increase in the mandatory disclosure of information by the publicly traded companies. The regulation became applicable from the financial year ended The research in the field of corporate governance is abundant in the context of the developed economies. There are, however, very few studies in corporate governance related to the emerging markets. The changes in the regulatory environment, consequent to the SEBI regulation on corporate governance, provide an opportunity to study the impact of the governance structures on the firm performance. The objective of this study is to determine the corporate governance mechanisms that are effective in reducing agency costs. Specifically, it intends to study the role of the foreign institutional investors in reducing the agency costs. The recent developments in the Indian securities market like the dual fungibility of ADR s and GDR s; dematerialization of share certificates; and availability of wide financial products such as equity, wholesale debt, retail debt, futures, options, index futures and commodity derivatives has attracted foreign capital inflows during the second half of the last decade. In the developed markets, literature has documented the effectiveness of institutional investors, including the foreign institutional investors, in monitoring the managers. It is to be investigated if the foreign institutional investors in India are effective in reducing the agency costs. Section 2 provides a brief review of the literature on agency costs and the corporate governance mechanisms. Section 3 elaborates the change initiated by SEBI in the corporate governance structure and the financial disclosure practices of the publicly traded companies in India. The hypothesis and the models for the purpose of the study are discussed in Section 4. Section 5 discusses the methodology adopted to examine the hypotheses and presents the empirical results. The conclusions and directions for future research are discussed in Section 6. 2

3 2 Literature Review 2.1 Agency Theory A firm can be owned by a single person or by more than one person. A firm owned by a single person is called a sole proprietorship concern. In this case the owner is the manager and his interests are no different from that of the firm i.e., maximizing the firm value. But in majority of cases a single individual cannot provide the entire capital, expertise and resources; and hence few individuals, with similar objective, collectively carry out the business. Limited liability company structure is the most preferred structure for a large business. In this structure large number of investors provide the risk capital. They are called shareholders. Shareholders have the residual claim on the assets of the company. Therefore, the right to control the use of the assets of the firm vests in them. They are the deemed owners of the company. Shareholders delegate the power to manage the company to board of directors. The board delegates the same to managers while retaining its role to monitor and control the executive management. Corporate governance literature views shareholders as the principal and manager as their agent and describes the relationship as principal-agent relationship. An agency relationship is defined as one in which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. (Hill & Jones 1992). The shareholders, of a widely held firm, practically do not have any control on the manager. The shareholders are only informed of the financial results on a periodical basis while the manager controls the firms assets. This structure provides an opportunity to the manager to expropriate shareholders wealth and to indulge in power-seeking behaviour resulting in waste of free cash flows. There is a scope for the manager to misappropriate the funds by way of transfer of money as loans to his own companies, or sale of the company assets to himself at a lesser price or pay himself more perks. The law considers shareholders as deemed owners and therefore, provides minimal protection to their interest. The structure of firm leads to the separation of ownership from control (Berle and Means (1932)). The divergence of interest between the owners and the managers, due to the separation of ownership from control, results in the agency costs. 2.2 Agency costs Jensen and Meckling (1976) argue that the value of a firm is maximized when it is fully owner-managed (i.e. when the owner, who has 100% shareholding, is the manager). In these cases the interest of the owner-manger is the same as that of the firm i.e., value maximization. The divergence of interest of the manger, who is not the owner, and the shareholder leads to reduction in the firm value. The difference in the value of the firm when it is 100% owner- managed and when the owner-manager has lesser stake is the agency cost. According to them, the agency cost is the sum of bonding costs, monitoring 3

4 costs and residual loss. Bonding costs are costs incurred by the managers to assure the owners that they will act in the interest of the later. Example being the cost incurred for explicit bonding against malfeasance on the part of manager. Monitoring costs are the costs incurred by the owners to monitor the actions of the manager. Examples are the cost incurred for the appointment of the auditors, appointment of Board of directors, installation of formal control systems, budget restrictions, etc. Residual loss is the reduction in welfare experienced by the principal because of such divergence of interest between the owners and the managers (Jensen and Meckling (1976)). Equity has agency cost and so does the debt. The usual form of agency costs for debt is the restrictions placed in the covenants for additional borrowing, which in turn affects the ability of the firm to invest in good investment opportunities. Other agency costs for debt is restructuring, bankruptcy and bonding costs. Since the agency cost of debt is also borne by the owner-manager, he will try to minimize the total agency costs. Jensen and Meckling (1976) conclude that the point at which the total agency cost, of debt and equity, is minimal will be the optimum capital structure for the firm. The operating expense ratio 5 and asset turnover ratio 6 are used in the literature as proxies for agency cost. Agency cost is directly related to operating expense ratio and inversely related to asset utilization ratio. A firm that has higher operating expense ratio than a base case firm (firm which is 100% owner-managed) has a positive agency cost. Similarly, a firm having lower asset utilization ratio that a base case firm has a positive agency cost. Ang et al (2000) find that operating expense ratio for base firms (owner-managed firm) are 46.4% and that of the outside-managed firms is 49.8%. The value of a firm if it is owner-managed is $ 180,000 more than when it is outsider-managed, for an asset value of $ 4,38,000. They conclude that owner-managed firms has 5.1 % lesser agency cost than outsider-managed firms and the agency costs are reduced by % for each 1 % increase in primary owner's ownership share. 2.3 Mechanisms for disciplining the managers It is theoretically and empirically established that separation of ownership from control leads to agency costs. To reduce these costs, there is a necessity to discipline the manager so that they act in the interests of the owners. The literature suggests two kinds of mechanisms to discipline the managers viz., the internal control mechanisms and the external control mechanisms Internal control mechanisms Internal control mechanisms are internal to the functioning of a company and broadly consist of the ownership structure, the board composition, the board size, the leadership structure and the managerial compensation. There have been numerous studies to 5 Operating expense/sales 6 Sales/Assets 4

5 evaluate the impact of these control mechanisms on the firm performance. The relevant literature for each of these variables is given below Ownership Structure The development of capital markets has attracted various types of investors like individuals, corporate investors, institutional investors, mutual funds and foreign investors to invest in the equity of publicly traded companies. The ownership structure is an important determinant of the corporate governance. Corporate ownership structure determines corporate behaviour, which in turn determines the corporate governance structure (Pedersen and Thomsen (1997)). There is a significant amount of theoretical and empirical studies dealing with the effect of ownership structure on the firm value, the most important being that by Jensen and Meckling (1976). In this paper the authors prove that the value of the firm when it is 100% owner-managed is much higher than when the proportion of stake of the owner-manager is reduced below 100%. They further state that when the owner-manager share in the capital reduces, he finds it profitable to receive more non-pecuniary benefits such as expensive buildings, high perquisites, more number of staff than required under him etc. thus knowing his expected behaviour, the buyers of the shares discount the value of the firm and pay less. One way to align the interest of the manager (when he holds significantly less than 100% of the equity) with that of the shareholders is by increasing his shareholding. There are two schools of thought on the impact of manager s shareholding. One is that when the manager s shareholding increases there will be alignment of his interest with that of the other shareholders and he will work to improve the performance of the firm. However, the other school of thought argues against the increase in the managerial ownership, since such an increase may lead to entrenchment. Few empirical results demonstrate that there is both alignment effect and entrenchment effect at different proportions of managerial shareholding. While few other studies show either one or no effect. The most important finding regarding the relation between managerial ownership and firm performance is that of Morck, Shleifer and Vishny (1988). They argue that at lower levels of managerial ownership, the manager would like to earn more profits and hence would align their interests with that of the shareholders. But at higher level (5% and above) the entrenchment / empire building effect is higher than the alignment effect, and at even higher levels (30% and above) alignment affect dominates the entrenchment effect. Hermalin and Weisbach (1988) also find similar results as Morck et al. They find that the managerial ownership is positively related to performance between 0-1% of managerial ownership, negatively related thereafter upto 5%, and again positively related from 5-20% and negatively related thereafter. Mudambi and Nicosia (1988) also find similar results in the financial services industry in the United Kingdom. Han and Suk (1998) find that alignment effect dominates if the managers own upto 41.8% of the share capital. They further find that beyond the limit of 41.8%, the mangers are able to control the Board of directors and so the entrenchment effect dominates the alignment effect. The above research studies provide evidence that the relation between managerial ownership and firm performance is non monotonic. 5

6 The studies conducted by Agarwal and Knoeber (1996), Himmelberg et al (1999) and Demsetz and Villalonga (2001) prove that there is no empirical relationship between the managerial ownership and firm performance. Large shareholders play a vital role in corporate governance. The importance of the institutional investors as good monitors has been emphasized in the Cadbury Report and the Kumaramangalam Birla report. Vishny and Shleifer (1998) argue that good corporate governance is a function of large shareholding and effective legal protection. Maug (1998) contends that large shareholders will be active monitors if the market is liquid because they can benefit from informed trading in covering their monitoring costs. Sarkar and Sarkar (2000) in a study of large shareholders and their role in corporate governance in India, prove that for all large shareholders, except for the Institutional investors, the increase in their stake beyond the threshold limit of 25% increases the firm value (the alignment effect). They further prove that as the foreign shareholding increases beyond the threshold value, the value of the company increases four fold. The ownership structure is an important component of corporate governance. However, the previous empirical studies provide mixed results about the relationship between the ownership structure and firm performance. This may be due to the difference in the treatment of the variables (endogeneity, exogeneity) or due to difference in the environment and countries' policies in which the companies operate Board Structure The board of directors, being the steward of a company, monitors and controls the functioning of the management executives. Board of directors should be independent from the management in order to effectively monitor the performance of the management. Considerable amount of empirical research has been done to find the relation between the board structure and the firm performance. Jensen (1993) argues that companies should take necessary steps to ensure an efficient Board in order to maximize the shareholder value. He further argues the strengthening of the following aspects of the board of directors: Effective board culture Timely flow of information from CEO to the board Finance aspects in planning; so the necessity of director from finance background Increase in the shareholding of the CEO and board members Board size limited to 7-8 members Meeting of the board members with managers below the CEO level to increase their horizon of knowledge about the functioning of the company. The board size does play an important role in corporate governance. The Board comprising of experts from different fields of management may help in taking the right strategic decisions. Too few members on the Board may dilute the ability to provide such a strategic direction to the company. On the other hand, too many people on the Board may lead to communication and coordination problems and increase their inefficiency. 6

7 Jensen (1993) states that a board size of 7-8 members is ideal. Yermarck (1996) finds that there is negative relationship between the firm value and board size. Conyon and Simon (1998) also confirm the negative relationship between the firm value and the board size. Having dealt with the board size, we discuss about the board structure as specified in the literature. The composition of the board of directors is vital for the growth and effective functioning of a company. The board of directors comprise of executive and nonexecutive directors. Non-executive directors possess expertise to monitor and control the actions of the top management (Fama and Jensen, (1983)). Weisbach (1988) finds a positive increase in stock performance in case of outsider dominated (independent directors) and mixed Boards Leadership Structure There are two types of leadership structure; i. Dual leadership structure where an individual holds both the positions of the CEO and the Chairperson of the Board. ii. Separate leadership structure where two different persons hold the positions of the CEO and the Chairperson. The literature elucidates two theories related to the leadership structure of the firm i.e., the agency theory and the organizational theory. According to the agency theory, duality may lead to entrenchment by the CEO (Finkelstein and D Aveni (1994)). Theoretically, it is demonstrated that separation of those two positions will enhance the performance of the company because in this structure, the potential to abuse the power by the CEO will be lower than that in the dual leadership structure. On the other hand, according to the organizational theory the managers expect clear lines of authority and hence prefer CEO duality to non-duality. The theory further states that the separation of the positions of the CEO and the Chairperson leads to diffusion of power and does not signal a strong leadership. Hence, in the case of CEO duality there is unity of command and clear lines of authority, which will in turn improve the firm performance. The empirical results in this regard are mixed; Rechner and Dalton (1991) find that separate CEO firms consistently outperforms, in terms of accounting based measures, the firms having dual leadership structure. Pi and Timme (1993) in their study of 112 US banks prove that separate titles, had lower costs and higher returns. While Coles et al (1997), Donaldson and Davis (1991) and Boyd's (1995) find a positive relation between performance and combined leadership. Baliga et al (1996) and Daily and Dalton (1997) however find no systematic difference between the two groups having different leadership structure Managerial Compensation The consequences of the managerial efforts can be measured but it is almost impossible to measure efforts as such. To ensure optimal utilization of resources by the managers there is a necessity to align their pay with performance. Performance related pay to the manager motivates him to maximize shareholder value but at the same time the board of 7

8 directors and the shareholders need to monitor that he is not paid in excess of what is reasonable based on industry norms and the performance of the firm. Marris (1994) and Kanniainen (2000) argue that the incentive of empire building can be reduced if pay is linked to profits net of cost of investment i.e., to the Economic Value Added. Similarly Mueller and Yun (1997) contend that higher the discretion with the manager to decide investments, the more should be their incentive linked pay. The Cadbury committee emphasizes the importance of remuneration committee and the presence of outside directors on such committees to ensure that the managers are not over paid. Similarly the Kumaramangalam Birla Committee also emphasizes the role of remuneration committee and the need for disclosures by firms about the remuneration paid to the directors and the managerial personnel in their annual reports External control Mechanisms External control mechanisms are the mechanisms that are external to the functioning of the firm over which the firm has no control. Whether the external control mechanism is more effective than the internal control mechanism is still an open empirical question. The internal control mechanism and the external control mechanism are not substitutes but are complements in monitoring the performance of managers and to control the expropriation of wealth by the insider owners. Among the external control mechanisms the market for corporate control and minority protection have an important influence on the firm performance Market for Corporate Control Internal as well as external control mechanisms are required to discipline the manager. If the board of directors fails to ensure shareholder wealth maximization, the market for corporate control becomes active. Takeover, thus, plays an important role in disciplining the manager. The probability of takeover and firm performance is inversely related (Morck et al (1989)). In the case of poorly performing firms, takeover shareholders favour and expect that the change in management will improve the firm s performance. This shareholders perception is reflected in the stock value of the target company on the day of takeover announcement. On the other hand the stock performance of the bidder firm is either negative or it does not change. This reflects the perception of the shareholders of the bidding firm that the manger of their firm is involved in empire building. Though the shareholders of the target firm benefit from takeover, the manager resist it so as to protect his job. The probability of takeover of a firm also depends on the ownership and the Board structure of the firm. Firms having higher ownership of the directors and the executives may be less susceptible to takeover since such companies usually perform well (alignment effect). Large blockholders also have a role to play in takeover. The ownership of large unaffiliated blockholders increases the probability for hostile takeover while that of affiliated blockholders reduces the possibility for hostile takeover (Shivdasani (1993)). 8

9 Protection to Shareholders The protection of investors from expropriation by managers and large shareholders has an important role in to play in determining the corporate governance structure in any country Protection of shareholders includes the efficient enforcement of the laws. Strong investor protection will strengthen the financial markets because the investors and institutions will be ready to invest in firms operating in those countries. La Porta et al (1997) demonstrate that countries with a better investor protection have strong stock markets with large number of shares listed and more number of Initial public offerings (IPO s) than those in countries where outsiders have lower protection. Johnson et al (2000a) in a study on the East Asian crisis find that the investor protection and enforcement is weak during the crisis period. Thus in order to have efficient financial markets, the country should not only have strong laws for protecting the shareholders and creditors but also strong judicial and regulatory system to enforce the law. La Porta et al (1999) argue that the difference in the empirical results found in the area of corporate governance is due to the difference in the protection given to minority shareholders and the creditors across different countries. 3 SEBI Regulation on Corporate Governance The financial disclosures made by the Indian listed companies prior to 2001 were limited. There was very little emphasis on the corporate governance mechanisms too. To address these issues and to strengthen the corporate performance, SEBI appointed the Kumaramangalam Birla Committee. Upon the recommendations of the Committee, SEBI issued a regulation (Code) applicable to all Indian listed companies from the financial year ended The recommendations of the Committee are implemented by incorporating the Code as clause 49 of the listing agreement. This clause requires listed companies to modify their governance structures in accordance to the Code, and disclose specified information in the Corporate Governance Report and in the Management Discussion and Analysis (MDA) as part of their annual reports. The objective of the Regulation is shareholder wealth maximization through good corporate governance structure and by reduction in information asymmetry. The Committee expects that appropriate Board and leadership structures will enhance the credibility of information being provided to the investors, which in turn will reduce the information asymmetry and increase the shareholder wealth. The applicability of the Committee recommendations is as follows: By all entities seeking listing for the first time, at the time of listing. Within financial year ,but not later than March 31, 2001 by all entities, which are included either in Group A of the BSE or in S&P CNX Nifty index as on January 1, Within financial year , but not later than March 31, 2002 by all the entities which are presently listed, with paid up share capital of Rs. 10 crore and 9

10 above, or net worth of Rs 25 crore or more any time in the history of the company. Within financial year , but not later than March 31, 2003 by all the entities, which are presently listed, with paid up share capital of Rs 3 crore and above. The Committee provided mandatory and non-mandatory recommendations on issues related to corporate governance and financial disclosures. The recommendations of the Committee are given as below. The mandatory recommendations of the Committee are; The Board of the directors shall consist of atleast 50% of non-executive directors. And if the chairperson is an executive director then atleast half of the Board of directors shall be independent and in other case atleast one-third of the total directors shall be independent. The audit committee should have atleast three non-executive directors out of which majority should be independent. The chairperson of the committee should be an independent director. It should have atleast one director with finance and accounting background. The Board of directors shall determine the remuneration of the nonexecutive directors. The corporate governance report, which forms part of the annual report, shall include information regarding the components of remuneration paid to its directors. The directors shall not be members of more than 10 committees or chairperson of more than 5 committees across all companies. In case of appointment/reappointment of directors, shareholders should be provided a resume, information regarding functional expertise and number of directorships held in other companies. Quarterly results should be placed on the companies web site. A Shareholders grievance redressal committee should be formed under the chairpersonship of a non-executive director. Every Annual report of a listed company shall consist of compliance report on Corporate Governance. The companies should provide Management, Discussion and Analysis as a part of their annual report. The non-mandatory recommendations are: Non-executive chairperson can maintain a chairperson s office at the company s expense. The remuneration committee should have atleast three directors all of whom shall be non-executive directors. The chairperson should be an independent director. Half-yearly financial results should be sent to each shareholder. 10

11 The Committee highlighted the importance of independent directors to ensure an unbiased judgment in Boards decisions. The Committee expects that appropriate mix of executive and independent directors is essential for the effective functioning of the Board. It also recommended that the Board of directors should form audit, remuneration and the nomination committees. The requirement to have an audit committee with nonexecutive directors strengthens the monitoring role of the Board. The audit committee has an important role to play in checking the fraud and manipulation within the company. The nomination committee of the Board recommends the candidates to be appointed as directors. The role of remuneration committee is to ensure that the managers and the directors are not overpaid. This report also emphasizes the disclosure of the related party transactions, so that there is transparency in the transactions between the company and the related parties. The qualifications, composition of and the remuneration paid to the directors (including performance-linked remuneration), the shareholding pattern of the company and the committees details should be disclosed as part of the Corporate Governance Report, MDA should consist of information regarding the industry structure and developments, opportunities and threats, segment wise performance, future outlook of the company and discussion on financial performance of the company. Some of the most critical financial/operational information lies within the scope of Management Discussion and Analysis (Vaidyanath (2003)). The MDA provides necessary information to investors about the risks and return related to the company. The information enables investors to compute the expected cashflows and thus facilitate them in appropriate valuation of the company. In the context of the change in the corporate governance mechanisms in India consequent to the introduction of the SEBI Regulation, this paper analyzes which of governance variables (individually or in combination) are effective in reducing agency costs. In the next section we discuss the hypothesis and the model used in the research study. 4 Hypothesis Development and Model The empirical findings, as discussed in Section 2, document the effectiveness of corporate governance mechanisms in enhancing the firm performance. In this section, we hypothesize that the ownership structure, the board structure and the leadership structure have an impact on the agency costs. Jensen and Meckling (1976) prove that the value of the company is positively related to owner-manager shareholding. He argues that the incentive for the owner-manager to misuse the funds is reduced with the increase in his shareholding; and as such there will be a reduction in the agency cost. In the context of Indian companies, Sarkar and Sarkar (2000) find that foreign shareholding and company value is positively related. It is expected that the foreign institutional investors play an important role in reduction of agency costs. On the basis of above arguments, we hypothesize that higher the promoter ownership and institutional ownership, foreign and Indian, lower is the agency cost. 11

12 It is expected that as the board size increases, coordination and communication problems increase, which in turn increase agency cost. Conyon and Simon (1998) confirm the negative relationship between the board size and company value. We surmise that larger the size of the board higher is the agency cost. Weisbach (1988) finds a positive relationship between company performance and independent director dominated boards. On the basis of this argument we conjecture that board with a higher proportion of independent directors is more effective in monitoring and caroling the executive management and thus reduces agency costs. It is also expected that a non-dual CEO 7 possesses lower informal power and hence companies having that structure have fewer agency costs than those firms with a dual CEO structure 8. Our hypothesis is Agency cost = f (Promoter ownership, Institutional ownership, FII ownership, Board size, Proportion of independent directors, Leadership structure) Hypothesis 1: The corporate governance mechanisms will not reduce the agency cost of the companies. Alternate to Hypothesis 1: The corporate governance mechanisms will reduce the agency cost of the companies. To deduce that the governance mechanisms are effective in monitoring the managers we use the model as given in equation.1. The operating cost ratio and the asset turnover ratio are used as proxies for the agency cost. These two ratios is used by Ang et al (2000) to compare the agency cost of firms that have lesser than 100% stake by the owner-manager with that of the firms which have 100% stake by the owner-manager. Our model to test the impact of the governance variables on agency costs is: Agency Cost = b + b Pmtr + b Insti + b FII + b BoardSize + b Indep + b CEO + e (1) _ i 0 1 i 2 i 3 i 4 i 5 i 6 i i Where, Agency_Cost is the proxied by two ratios i.e., operating ratio and Asset turnover ratio; Operating ratio = Total Operating Cost / Total Cost; Asset turnover ratio = Net Sales / Total Assets; Pmtr is the promoter ownership in the i th company; Insti is the Indian institutional ownership in i th company; 7 Where the Chairperson of the Board and the CEO are different persons. 8 Where the CEO is also the Chairperson of the Board 12

13 FII is the foreign institutional ownership in i th company; BoardSize is the number of Board members in i th company; Indep is the proportion of independent directors to the total number of directors in i th company; CEO is a dummy variable, =1 for a company having dual CEO = 0 for company having non-dual CEO e i is the error term independent and identically distributed (i.i.d.) N(0, σ 2 ) i = 1, 2,.n firms. The model as defined equation (1) can be used subject to the homoskedasticity between the group of companies having CEO duality and the group of companies having no CEO duality. If the condition of homoskedasticity is not satisfied, then the dummy representing CEO duality is dropped and separate analysis of each of the groups is conducted using the model in equation (2). Agency Cost = b + b Pmtr + b Insti + b FII + b BoardSize + b Indep + e (2) _ i 0 1 i 2 i 3 i 4 i 5 i i 5 Data and Methodology For the financial year ended 2001 companies belonging to the BSE A Group and those comprising of the NSE Nifty index have to comply with clause 49 of the listing agreement. A total of 134 companies form part of the BSE A Group and Nifty as on the 1 st January, The remaining listed companies are not required to comply with the Regulation for the FY ended There are few companies that were not required to but have complied with the Regulation. However, we study only those companies that were required by law to comply with the provision of the Regulation for the financial year ended For the purpose of our study we use 3 years data from financial year ended 2001 to financial year ended We analyse the effect of governance variables (individual and altogether) for each of these years. The consistency of results across the 3 years will strengthen our analysis. Data for the purpose of the study is obtained from Prowess; the financial database maintained by CMIE Pvt. Ltd. 9 The Board structure variables is obtained from the company annual reports which are also provided in the Prowess database. 9 Center for Monitoring Indian Economy Private Limited 13

14 Table.1.Details Regarding the Sample Size Experimental Group Companies required to comply with the Regulation 134 Companies with different financial year ended 29 Companies with market capitalisation less than 1 cr 3 Initial sample 102 Companies for which all the data across 3 years is not available 26 Final sample size 76 Table.2. Descriptive statistics of the variables in the sample for FY 2001 N Minimum Maximum Mean Std. Deviation Promoter Ownership Institutional Ownership FII Board Size Proportion of Independent Directors Operating Cost Ratio Asset Turnover Ratio CEO_dummy Table.3. Correlation Coefficient between the variables for FY 2001 Pmtr Insti FII BoardSize Indep Opt. Cost ATO CEO Pmtr Insti -.55** FII -.282* 0.01 BoardSize * Indep -.281* Opt. Cost **.257* -.329** ATO.294** * 0.1 CEO * *Significance at 5% level **Significance at 1% level 14

15 Table.4. Correlation Coefficient between the variables for FY 2002 Pmtr Insti FII BoardSize Indep Opt. Cost ATO CEO Pmtr Insti -.481** FII -.330** BoardSize Indep -.399** * -.236* Opt. Cost ** * ATO.394** CEO *Significance at 5% level **Significance at 1% level Table.5. Correlation Coefficient between the variables for FY 2003 Pmtr Insti FII BoardSize Indep Opt. Cost ATO CEO Pmtr Insti -.380** FII -.324** BoardSize Indep * Opt. Cost * -.322** * ATO.380** CEO *Significance at 5% level **Significance at 1% level A preliminary analysis of the effect of the governance variables on the agency cost can be made from data in Tables. 3 to 5. We find that operating cost is negatively correlated to FII and the proportion of independent directors. The correlation is significant at 1% level. At 5% level of significance we find that the operating cost is positively correlated to the Board size. In the case of asset turnover ratio, it is significantly correlated to the promoter ownership at 1% level. These correlations support our hypothesis that FII and proportion of independent directors are negatively related to the agency costs. From the same table we also find that there is significant correlation amongst the independent variables. This violates the assumption of multiple linear regression model that the independent variables are uncorrelated. And the multiple regression equation comprising of all these independent variables may not give significant results. As an alternative we regress each of the independent variables separately on the dependent variable; and also regress all the independent variables together on the agency cost. To use a dummy for CEO duality, the basic assumption of homoskedasticity between the two groups should be satisfied. However we find that for both the proxies there is no homoskedasticity between the group of companies having CEO duality and those having no CEO duality. This result is consistent across all the 3 years. Hence, for the purpose of further analysis we deal each of the groups separately. Tables 6 to 17 contain the regression results. Summary of the regression results is given in Tables 18 to 22. The 15

16 summary tables are based on the results of regression obtained from (1) to (5) of the relevant tables. Table.6. Companies with CEO duality Year 2001 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors * 2.858* 2.408* FII % Indep Director * Board Size * 2.032* 1.969* R Square Std Error of Estimate F Statistic Sig of F Statistic N * Significant at 5% level Significant at 10% level Table. 7. Companies with no CEO duality Year 2001 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII * * * % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

17 Table. 8. Companies with CEO duality Year 2002 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII * * % Indep Director * Board Size * 2.006* R Square Std Error of Estimate F Statistic Sig of F Statistic N Table. 9. Companies with no CEO duality Year 2002 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

18 Table. 10. Companies with CEO duality Year 2003 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII * % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N Table. 11. Companies with no CEO duality Year 2003 Dependent Variable: Operating Cost ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

19 Table. 12. Companies with CEO duality Year 2001 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter Institutional Investors FII % Indep Director * Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N Table. 13. Companies with no CEO duality Year 2002 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter * Institutional Investors * FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

20 Table. 14. Companies with CEO duality Year 2002 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter * 2.462* Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N Table. 15. Companies with no CEO duality Year 2002 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter * Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

21 Table. 16. Companies with CEO duality Year 2003 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter * 2.297* Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N Table. 17. Companies with no CEO duality Year 2003 Dependent Variable: Asset Turnover ratio Independent variables (1) (2) (3) (4) (5) (6) (7) (8) Promoter * 2.306* 2.418* Institutional Investors FII % Indep Director Board Size R Square Std Error of Estimate F Statistic Sig of F Statistic N

22 Table. 18. Summary Table of Companies with CEO Duality Dependent Variable: Operating Cost Ratio Year Promoter Institutional % Indep Board FII Investors Director Size 2001 Positive Negative Negative Positive 2002 Negative Negative 2003 Negative 10% level of Significance, while others are at 5 % level of Significance Table. 19. Summary Table of Companies with no CEO Duality Dependent Variable: Operating Cost Ratio Year Promoter Institutional % Indep FII Investors Director Board Size 2001 Negative 2002 Negative 2003 Negative 10% level of Significance, while others are at 5 % level of Significance Table. 20. Summary Table of Companies with CEO Duality Dependent Variables: Asset Turnover Ratio Year Promoter Institutional % Indep FII Investors Director Board Size 2001 Negative 2002 Positive 2003 Positive The results are at 5 % level of Significance Table. 21. Summary Table of Companies with no CEO Duality Dependent Variables: Asset Turnover Ratio % Institutional Year Promoter FII Board Size Investors 2001 Positive Negative 2002 Positive 2003 Positive The results are at 5 % level of Significance Independent Director The results of the summary tables establish that the FII have been effective in reducing the agency costs (proxied by the operating cost ratio) for all three years from 2001 to The results also demonstrate that the promoter ownership has a positive relationship with the asset turnover ratio providing evidence of the alignment effect as mentioned in the literature. The impact of FII and the promoter ownership as mentioned above is documented for both the groups of companies. For the companies belonging to the CEO duality group we find that the proportion of independent directors has been 22